In all, pretty much the same thing applicable to all banking crisis. The same guidelines apply to banks all the time irrespective whether there is a crisis or not.

I would suggest more crucial is to understand why weren’t these basics of banking/finance applied? Why did banks take the kind of risks they did? What was risk management doing when traders/loan-makers were taking risks? Where did corporate governance, business ethics go? It doesn’t help in any learning.

After understanding the actual practices from the assumed only we can make some progress on designing appropriate policies. There is no point restating things which have been well-known and are obvious.

Like this:

Willem Buiter has a great blog but is always difficult to read. It is very detailed and has loads and loads of information and facts. Most of his posts are like a research paper. He says clearly he writes the blog for himself as it helps him.

I had pointed to his superb study on how and why Iceland failed. In taht study he says:

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
(1) A small country with (2) a large, internationally exposed banking sector, (3) its own currency and (4) limited fiscal spare capacity relative to the possible size of the banking sector solvency gap.

Countries that come to mind are:

Switzerland

Denmark

Sweden

and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

In his latest post, he works on UK economy and provides evidence why UK could go the Iceland way. A must read.

I came across this wonderful speechby Lorenzi Bin Smaghi, ECB member comparing the economic policies between US and Euroarea. He analyses policies across spectrum- monetary, fiscal etc.

The United States and the euro area are the two main economic and monetary areas in the world and they are reasonably similar in size, with a population of over 300 million (300 million in the United States and 320 million in the euro area) and GDP of around €10,000 billion at current prices (at the going rate of exchange of around USD 1.30 to the euro – US GDP is worth around €11,000 billion, while euro area GDP is worth around €9,000 billion).

After this, he points to how policies are determined in the two regions:

In recent years, the two economies have been compared in a largely asymmetrical way, possibly a hangover from an obsolete institutional setup and analytical reference framework. While in the United States economic policies are mainly assessed on the basis of the US economy’s underlying state, in the euro area the assessment is made on the basis not only of European economic fundamentals, but also, and indeed above all, with reference to economic policy decisions made on the other side of the Atlantic. On our continent, monetary and budgetary policies are often judged in relation to what is decided in the United States rather than in their own right. However, it is very rare that the opposite happens.

This kind of asymmetrical assessment was perhaps alright under the Bretton Woods system, in which the European countries pegged their currencies to the dollar, and under the subsequent fluctuating system in which the individual European countries were relatively small, which allowed them to benefit from a certain amount of autonomy from the decisions reached on the other side of the Atlantic. But with the creation of the euro and the development of the euro area to levels akin to the US economy, it would have been rather ironic if economic policy decisions in Europe simply mirrored the conduct of other authorities.

He then points why policies in Euroarea ought to be different compared to in US economy. US economy is more dynamic compared to Euro and impact of shocks differ in both regions requiring different policy responses.

Like this:

In its previous meeting on 6 Nov 2008, BoE had cut rates by a shocking 150 bps making it the largest rate cut in UK’s monetary policy history and also the largest cut amidst central banks (barring Iceland). The markets had expected 50-100 bps. All eyes weer on the minutes of the meeting,

The projections in the Inflation Report implied that a very significant reduction in Bank Rate – possibly in excess of 200 basis points – might be required in order to meet the inflation target in the medium term. However, a number of arguments were discussed for not moving Bank Rate by the full extent implied by those projections.

There were 4 points which led to a 150 bps rate cut:

First, the projections had used the normal convention that they were based on the Government’s most recent published tax and spending plans.

Second, although the banking measures that had been introduced around the world had restored a degree of stability to the banking system, it was unclear how the supply of broad money and credit to the wider economy would respond.

Third, a key concern was the degree of surprise to financial markets. Too large a surprise could pose upside risks to the inflation target if the resulting depreciation of sterling was excessive.

Fourth, some members thought there was an argument for leaving some of the required policy loosening to the months ahead to support confidence as the economy weakened.

Hence, because of the uncertainty in the economy and need to have some weapons to fight the looming collapse, BOE did not pass a 200 bps rate cut. One can expect similar/steeper rate cuts in the next meeting on 3 & 4 December. It shouldn’t be a surprise.

Like this:

There was a paper in October 2008 by Minneapolis Fed Economists which said bank lending has not declined and has infact increased. This created quite a stir as all along we have been expecting it to be opposite. They look at 4 supposed to be facts right now and say they are myths instead:

Bank lending to nonfinancial corporations and individuals has declined sharply.

Interbank lending is essentially nonexistent.

Commercial paper issuance by nonfinancial corporations has declined sharply, and rates have risen to unprecedented levels.

Banks play a large role in channeling funds from savers to borrowers.

There are 2 papers which look at the Minneapolis Fed paper and both disapprove the findings. One is by Boston Fed economists and other by Victoria Ivashina and David S. Scharfstein.

Boston Fed paper provides more disaggregated data compared to Minneapolis Fed paper and shows that first three are reality and not myths. On fourth, they say more analysis is needed.

The second paper by Ivashina provides further analysis:

Fact 1: New lending in 2008 was significantly below new lending in 2007, even before the peak period of the financial crisis (August-October 2008)

Fact 2: The decline in new loans accelerated during the financial crisis, falling by 36% in the August-October 2008 period relative to the prior three-month period.

Fact 3: Real investment loans (working capital or general corporate purposes) and restructuring loans (those for M&A, LBOs, and stock repurchases) have decreased to a similar extent.

Fact 4: During the peak period of the financial crisis (August-October 2008), noninvestment- grade loans fell by 50% relative to the prior period, while investment grade loans fell by 19%.

However, Ivashina provides a caveat which is quite interesting and is a further scope for research:

New lending has declined during the financial crisis. However, it remains unclear whether this decline is supply or demand driven. Are banks withholding funding from creditworthy borrowers who need financing? Or are firms cutting investment in response to concerns about the economy, and thus choosing not to borrow?

To address this issue, we are investigating the differences in the way banks have responded to the financial crisis. Have banks with more impaired loan portfolios scaled back their lending more? Likewise, have banks with a larger revolver overhang cut their lending more to protect themselves against the risk of large revolver drawdowns? And, how have banks responded to the credit guarantees and equity infusions that the U.S. government has recently provided?

Loads of research expected on the issue and is going to be very interesting.

On reading the testimonies, one comes across mix views and there is no clarity. However, most of them lean towards the need to regulate hedge funds.

The most interesting of the testmonies was of George Soros ( that is a given):

The salient feature of the current financial crisis is that it was not caused by some external shock like OPEC raising the price of oil or a particular country or financial institution defaulting. The crisis was generated by the financial system itself. This fact-that the defect was inherent in the system-eontradicts the prevailing theory, which holds that financial markets tend toward equilibrium and that deviations from the equilibrium either occur in a random manner or are caused by some sudden external event to which markets have difficulty adjusting.

This is typical Soros stuff. After this, he says to understand the events, we need a new theory

This remarkable sequence of events can be understood only if we abandon the prevailing theory of market behavior. As a way of explaining financial markets, I propose an alternative paradigm that differs from the current one in two respects. First, financial markets do not reflect prevailing conditions accurately; they provide a picture that is always biased or distorted in one way or another. Second, the distorted views held by market participants and expressed in market prices can, under certain circumstances, affect the so-called fundamentals that market prices are supposed to reflect. This two-way circular connection between market prices and the underlying reality I call reflexivity.

Soros then explains the way the distorted views lead to bubbles and problems. It has helped a certain section:

Although market fundamentalism is based on false premises, it has served well the interests of the owners and managers of financial capital. The globalization of financial markets allowed financial capital to move around freely and made it difficult for individual states to tax it or regulate it. Deregulation of financial transactions also served the interests of the managers of financial capital; and the freedom to innovate enhanced the profitability of financial enterprises. The financial industry grew to a point where it represented 25 percent of the stock market capitalization in the United States and an even higher percentage in some other countries.

He then explains the political economy of financial markets and says efficient markets ideology became mainstream as crisis impacted the developing (those that had poor macro, poor institutions etc). Whenever crisis occurred in US like LTCM , Savings and Loan crisis etc authorities intervened and a largescale crisis was averted. And the ideology continued to prosper. He says he cried wolf 3 times:

I have cried wolf times: first with The Alchemy ofFinance in 1987, then with The Crisis ofGlobal Capitalism 1998, and now. Only now did the wolf arrive.

However, his theory lacks predicting events in fin markets. It helps more explain them. So, it still lacks a much needed aspect of fin system. He then says the regulators need to do something to manage the build oup of bubbles as their policies lead to creation of the same. He does not have very kind words for Alan Greenspan as well.

Finally on hedge funds he says:

Regarding hedge funds, it has to be recognized that hedge funds were also an integral part of the bubble which now has burst. Hedge funds grew to approximately $2 trillion of capital which at times controlled as much as $10 trillion or more in assets. But the bubble has now burst and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent. During the current financial crisis, many hedge fund managers forgot the cardinal rule of hedge fund investing which is to protect investor capital during down markets. It is unfortunate that much of the money raised by hedge funds in pursuit of alpha

Like this:

The role of incentives in generating this financial crisis has been much debated and criticised. As a result, some changes are happening.

First, most of the govt. packages have this as the first condition- no bonuses, golden parachutes etc. Second, role of compensation structures has been included in various reports prepared for future financial regulation. Third, even companies are waking up to their mistakes and making changes.

UBS has released a report detailing changes in its compensation model. The detailed report is here and there is also a FAQ on the same. In the new model, following issues have been done away with:

Variable compensation was strongly aligned with short-term results, without consideration for the quality or sustainiability of the bank’s performance

The system for determining variable compensation did not sufficiently take into account the risks assumed.

As a result, there will be no variable pay (bonus etc) for this year for the top management and for others it will be reduced.

This is actually in line with what Goldman Sachs has done but is different as it has issued a separate report and plans to stay committed to the plan. Just to recall, UBS was also the first one(and I think only one) to issue a report explaning its losses to the shareholders. The report was highly complex and one could not make any sense of the problems.

Like this:

The economics/finance professors have been accused for not being able to predict the crisis. Infact they are often blamed for instead engaging in random academic work not benefiting anyone.

I came across this article (thanks to ASBfor the pointer) in American which says the contrary. It summarises research of economists which has pioneered work that has led to predicting wrongdoing in certain segment of financial markets (mutual finds, backdating options etc) and economy (sub-prime borrowing). The links to the various papers cited have not been provided and would involve some google searching.

A good article which shows things are not as bad as they are made out to be.

However, what is needed is to make the academic work more mainstream and spread the message via newspapers, blogs etc. Apart from Ed Gramlich (who predicted risky sub-prime borrowings), Jay Ritter (IPO mismanaging), I haven’t heard of any of the professors and their work.

As it can be seen, outstanding CDS have declined from USD 57.9 tn to 57.3 tn. All other derivative instruments, there is robust growth. This report has got much more analysis like Herfindahl index for measuring market concentration etc.